Meta

Month: March 2011

Though I disagree with George Santayana’s pragmatist philosophy, I couldn’t agree more with his remark that “Those who cannot remember the past are condemned to repeat it.” I have thus endeavored to become a student of stock market history to avoid the condemned thing.

Market history is boring and frustrating to think about for most, but I will try here to simplify it for you. Tell me how I do.

Stocks are priced, over time, relative to the earnings of underlying companies. Sometimes market participants are optimistic and willing to pay a lot for underlying earnings, sometimes they are pessimistic and willing to pay little, and most of the time they are somewhere in between.

20% of the time they are optimistic: happily accepting less than 4% annualized returns to buy stocks

15% of the time they are pessimistic: demanding 16% or greater returns to buy stocks

65% of the time they are in between: expecting something between 4% and 16% returns from stocks

Briefly, in March 2009, investors were pessimistic enough to demand 16% returns. At present, they are happily accepting less than 4% returns.

With that very brief and simplified market history, let me be bold now and predict the future. Please wait a second while I gaze into my crystal ball…

…I see people getting less than 4% returns in the future, I see them getting very pessimistic at times, very optimistic at others, and spending the majority of the time in between.

Okay, I don’t really have a crystal ball, but that’s what will happen if you invest in the market today. The past will repeat and those who haven’t learned will being doing the condemned thing.

Oh, and by the way, you don’t have to invest in the market. Instead, you can–right now–buy pessimistically priced companies and sell optimistically priced ones. That’s another lesson of market history, but it’s not as simple.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

I’m very proud of my investing record over the last 6 years as a professional (beating roughly 80% of my competitors) and the last 15 years as an individual (beating the S&P 500 by over 4.5% annualized), but it could always use improvement. For, as Goethe put it, “he who moves not forward, goes backward.”

With that in mind, I’ve spent a lot of the last few months reviewing my investment process and looking for ways to improve. One of the most important lessons I have derived is the importance of not investing in things that go down a lot.

Now, this may seem perfectly obvious to you, but it’s hard when one is busy with day to day research and portfolio management to focus on the downside instead of the upside.

In fact, I’d go so far as to say that most people focus too much on the upside–myself included. Most people seem to believe that hitting the ball out of the park is the way to win baseball games, when in fact it has more to do with not striking out and getting base hits.

So it is with investing. I’m a devoted fan of Warren Buffett, so this thinking should be more implicit in what I do. Buffett describes his two investing rules quite simply:

Rule #1: don’t lose money

Rule #2: don’t forget rule #1

Or, as Alice Schroeder, Buffett’s authorized biographer, described it in a presentation at the University of Virginia: Buffett’s first step is to look for catastrophic risk. If he sees any possibility of catastrophic risk, he just stops right there and moves on to other ideas.

I was struck recently with how little I’ve devoted to this side of the process. How do you not lose money? Don’t invest in things that go down a lot. If you avoid blow-ups, then the upside will take care of itself.

Charlie Munger, Buffett’s business partner, likes to quote famed German mathematician, Carl Gustav Jacob Jacobi, on this issue. Jacobi told his students to “invert, always invert” (the quote on Wikipedia is “man muss immer umkehren,” which I translate as “one must always invert”). What Jacobi meant was that many problems can be solved backwards by inverting the problem.

For example, do you want to know how to be happy? Instead of trying to figure out how to be happy by examining happiness or looking at what happy people do, look for what you absolutely know will make you unhappy and then don’t do that. See the subtle difference?

If I study business successes, I may find out what common characteristics business successes possess, but that’s not the whole picture. I must also look to see if business failures share those same characteristics to avoid hasty generalization. Perhaps 5 businesses were successful by selling widgets and 95 were failures, so looking only at the 5 successes may lead me to falsely conclude that selling widgets is the way to success. I must also study the failures to see the full truth.

With that in mind, I can invert the problem as Jacobi suggests. What causes businesses to fail? If I know the answer well, and that business successes don’t do it, then I can avoid blow-ups by avoiding businesses with failure characteristics. Invert, always invert, indeed.

So, not surprisingly, I’ve decided to become a student on what makes businesses fail. By inverting the problem to avoid failures, I will ensure greater success in my investing results.

Thank you Buffett, Munger and Jacobi.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

So much ink has been spilled–especially over the last several years–about the rise of China that I wanted to devote a blog to the subject.

I won’t bury the lead: I believe China is more likely another Japan than another United States on the rise. My goal is not so much to tell the future–I don’t know what will happen–as much as it is to cast doubt on the overwhelming consensus of China’s inevitable rise to supremacy.

What consensus you might ask? That China’s economy will inevitably surpass the U.S.’s in the next 10, 20, or 30 years; that China will surpass the U.S. in technological superiority; that China will surpass the U.S. militarily; that China will surpass the U.S. in every way possible, it seems.

All of these things very well may come to pass. But, it is not written in the stars, and the consensus view is almost entirely built on an extrapolation of current trends–a technique of forecasting which is almost never accurate.

As an interesting illustration of forecasting difficulty, I’d like exhibit #1 to be Paul Kennedy’s excellent book, The Rise and Fall of the Great Powers. Now, granted, this book came out in 1987, when Japan’s ascendancy was widely accepted as given, but it’s a wonderful example of how someone extremely knowledgeable in a specific field can suffer from the biases of extrapolation.

In his book, he speaks of the 5 centers of power at the time: the U.S., the U.S.S.R., Japan, China and the European Economic Community. He spells out how clearly Japan is surpassing or going to surpass the U.S. in computers, robotics, telecommunications, automobiles, trucks, ships, biotechnology and aerospace.

Please understand, he was writing in 1987, when Japan Inc. was thought to be unbeatable, buying up property all over the world, technologically unstoppable. He didn’t know Japan would fall into an economic funk a mere two years later where Japan’s economy wouldn’t grow for the next 22 years (nor did he see the fall of the U.S.S.R. coming, and even seems to poo-poo the idea). So much for Japan Inc. and extrapolation of the past.

But, really, how could anyone really think that Japan would surpass the U.S. in computers and software? Or biotechnology and aerospace? Yes, Japan has definitely done better in robotics, automobiles and ships, but to provide such a long and overwhelming list as a historian? A bit naive, I think.

The consensus view on China reminds me in many ways of the view 20 years ago of Japan. Don’t get me wrong, Japan and China are very different stories, but people’s perception seems to be similar.

Just as China’s centrally planned economy and “state capitalism” (an oxymoron if there ever was one) is seen as the wave of the future and a better way to govern, so Japan’s Ministry for International Trade and Industry (MITI) and it’s coordination of economic activity was seen as a huge advantage over the U.S.’s capitalism.

Just as China’s production of engineers and scientists is seen as an unstoppable force, so was Japan’s. Just as China’s high research and development budget is seen as superior, so was Japan’s.

Just as China’s high national savings rate is seen as an advantage over the U.S.’s consumption, so was Japan’s. Just as China’s superiority in aptitude tests is seen as intellectually over-powering the U.S.’s poor scores, so was Japan’s.

I believe people make these extrapolations because they don’t really understand the sources of growth. They simply expect the recent past to keep going, but it almost never does.

Just as Japan’s extraordinary growth came from adopting western technology and industry and having huge western markets to sell to, so does China’s. If either Japan or China had had to create these industries from scratch, as the U.K. and U.S. had done, the growth would never have materialized. And, just as Japan’s economy has demonstrated over the last 20 years, if China ever has to rely on it’s own consumers and businessmen for innovation and growth, you’ll see growth fall off a cliff.

Neither Japan nor China invented the Bessemer process, or assembly lines, or transistors, or binary computer logic, or almost any of the other major innovations which allowed them to grow. They got it all from the west.

And, this brings me back to my blog of two weeks ago, where I said that return on capital is the most important concept in finance. You see, neither Japan nor China view return on capital as a primary concept. Japanese businessmen are frequently on record saying that the U.S.’s focus on shareholder returns is ridiculous. China is a communist state that sees returns on investment as a mere means to other ends.

The U.S. and U.K., at least during periods of innovation, let returns on capital as determined by individuals allocate resources, instead of some central planning bureaucracy. The U.S. and U.K., thanks to intellectual greats like Adam Smith (a moral philosopher, not economist), recognized that human potential was unlocked when individuals were able to pursue their self-interest, as long as there was a rule of law and, specifically, protection of property rights.

Good luck finding that intellectual framework in Japan or China.

In forecasting the future, this return on capital concept is vital to accuracy.

If the U.S. abandons its focus on return on capital (as the U.K. has in most ways done), good-bye growth and innovation, good-bye technological and military superiority, good-bye world leadership.

If Japan adopts a focus on return on capital at the individual level, which I believe is possible over time (perhaps in the next decade) welcome back growth and innovation.

If China adopts a focus on return on capital at the level of the individual–an unlikely route, in my opinion–it can become a leading state. Without that focus, growth will eventually crash and burn as it did in Japan (China is witnessing a boom in real estate, just as Japan did before its crash–coincidence?).

Forecasting China or U.S. over the next 30 years seems a bit silly without a focus on return on capital, but the consensus opinion is that it’s a done deal–China will be supreme.

I beg to differ because I don’t believe large population, numbers of engineers, test scores or central planning are the lifeblood of growth, but the innovation of individuals who produce high returns on capital for their own benefit.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Before deciding to have a child, my wife and I did a tremendous amount of research on how best to parent. It occurred to us both, early on, that one of our jobs would be to comfort her when she was cast down, and challenge her when she was feeling too self-satisfied.

This reminds me, in a lot of ways, of what an investment advisor must do for clients.

Too many investment advisors are eager to give clients what they want, not what they need (we all know how that parenting style works). In such a relationship, the advisor benefits at the expense of clients. Not good.

Most investors get overly excited about market prospects after investments have made big gains, then become overly despondent when investments tank. This is not some great sin on the part of investors–it’s a well tested and documented human tendency.

Investors who don’t exhibit this tendency, and there are quite a few, don’t really need an investment advisor. If they tend to zig when others are zagging, their investment results are likely to be very good without the help and expertise of an advisor.

Investors who exhibit the all-too-human tendency referenced above, however, do need the help of an adivsor. In fact, I would argue it’s the advisor’s most important job to prevent clients from buying at market tops and selling at market bottoms.

I’ve made this focus the centerpiece of client communications. When markets look frothy, I write client letters and blogs that express concern and cautious action. When markets look abandoned, I express enthusiasm and a need for bold action.

This is vitally important, because most investors won’t get anywhere close to meeting their retirement goals if they buy at tops and sell at bottoms. If you need concrete examples, please see any of the multitude of studies showing how unprepared baby boomers are for retirement.

So, it was with great distress that I read an article in SmartMoney today highlighting that 1/3 of advisors moved client dollars out of the stock market and into conservative investments (cash and bonds, mostly) in 2009 and early 2010.

In other words, those advisors were doing just the opposite of their most important job. Instead of talking clients off the ledge, they were facilitating their jump.

Even if you could argue that those clients needed to get out of the market for psychological reasons (can’t sleep at night), I would further suggest they didn’t belong in the market to begin with, and that their advisor should have been the one to figure that out before the market tanked.

Any advisor worth their salt should have been able to see that in early March 2009, the stock market looked likely to provide 20% annualized returns in the future (10% earnings yield, plus 6% economic growth, plus 4% dividend yield). This is not rocket science, but many investment advisors panicked just like their clients.

It’s like a pilot running up and down the isles of an airplane with an engine fire instead of soberly resolving the problem. Such a pilot is clearly not doing their job, and neither is such a panicky investment advisor.

Can you imagine if 1/3 of pilots panicked like passengers when problems occurred? No one would be willing to fly on an airplane!

And, yet, investors have and will continue to pick investment advisors based on their community involvement and winning personality, instead of their sober-minded expertise and an ability to deal successfully with psychological stress.

Perhaps investors will learn their lesson this time, and turn to advisors who give them what they need, not what they want.

After all, isn’t that a parent’s job, too?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

I was going to write a blog about why I think China looks more like developing Japan (with the same dreadful destination) than developing America, but realized I just couldn’t get there without an intermediate step.

That intervening step may seem like a minor point, but I believe it’s the most important concept in finance and one of the most important in economics: return on capital.

Okay, of the 10 people reading this blog, I just lost 80% with that last sentence, so thanks for sticking around remaining 2!

Return on capital probably seems like either a very mundane or overly abstract concept. Everyone knows that for any financing to work, the financier must get his capital back and then some. Otherwise, why bother, right?

But, it seems like people frequently drop this context when they discuss broader issues.

Take college loans for example. If you lend someone more money than they could possibly repay to go to college, it’s not economic. But, you’ve got to do the math to really grasp this concept.

If you lend someone $100,000 to go to college, and they earn a degree that pays $20,000 a year, then it would take 20% of their pay ($4,000) for the rest of their life just to service a 4% interest rate–and that’s without paying any of the principal!

No intelligent financier would ever make such a loan, yet most people think the financier is being mean. What they should recognize is that such a loan is bad for the borrower and society just as much as for the financier–such a loan saddles the borrower for life and reduces the productive capacity and standard of living for the whole economy. It’s not mean, it’s just a plain stupid.

In 2006, I would have been laughed at for suggesting that many home loans were being done under the same uneconomic conditions. I hope that 2007-2009 has convinced most people of the soundness of this logic. If you can’t get a positive return on capital, it screws up the whole economy and wrecks the lives of those involved. If you can’t get a positive return on capital, it’s not financial or economic, it’s charity.

Society does not grow and prosper by charity, it requires a positive return on capital. For those who wish we were ants or that reality was other than it is, this may be a real downer, but that’s the way it is.

In order to meet our current and growing needs, we need to produce more this year than last, and the only way to do that is to get a positive return on capital.

What, exactly, does that term mean, anyway? It means if you borrow $10 from someone, you need to be able to pay them back the $10 plus whatever makes it worth their time. Or, more importantly, it means that you need to do something with that $10 that will generate $10 plus interest.

Or, more fundamentally, it means that if you buy 10 pieces of wood for $10, you better be able to turn those 10 pieces of wood into something worth more than $10, or you’re wasting your time and someone else’s money.

Or, even more fundamentally, if you don’t produce something worth more than $10, then you’ve reduced the productive capital available and thus lowered everyone’s standard of living (please see Peter Schiff’s How an Economy Grows and Why It Crashes for an excellent, very readable, and more thorough illustration).

This is not a minor point, I hope you can see. If you lend someone $10 and they can only pay back $9, it’s not just bad for you, it’s bad for them and for the rest of society. Those 10 dollars were earned by your time, effort and resources, which you can never get back. That $1 is done, gone, kaput!

Perhaps dollars is an inadequately concrete way to describe this point. Suppose you had 10 pieces of wood and you destroyed one by fire without producing any product or service. Nothing you can do will bring that piece of wood back. That wood can’t be used for fuel, or be turned into furniture, or anything else ever again. Time and effort would have to be expended to gain a new piece of wood–time and effort could have been used productively instead of simply bringing things back to the way they were before.

Return on capital isn’t just nice to have, it is a very concrete description of what is necessary to maintain and grow our standard of living. We must use our resources wisely such that they produce more and more each year.

It’s the bedrock upon which our world is built, and if taken too lightly, our foundation and prosperity will suffer.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.